A “captive insurance company” is created when a company decides that rather than paying an insurance company to protect against losses or claims, the company will instead self-insure. To do so, the company often works through a captive manager to create an insurance company that has a pool of funds that will directly handle—i.e., pay out—any claims. There are fantastic tax benefits that usually generate interet in establishing a captive as the company that pays the insurance premiums is able to take a tax deduction, but the insurance company does not pay tax on the receipt of those premiums. The tax incentive can often outweigh the actual business purpose of the arrangement and this often creates the ire of the IRS.
First and foremost, it’s important to recognize that a captive insurance company needs to be a real company, complying with a governmental agency’s registration, taxation, and other requirements. The captive insurance company needs to be sufficiently capitalized to pay out relevant claims—since, obviously, the inability to pay necessary claims would be catastrophic—and it needs to be actually paying claims. Inorder to pass muster, you might see over 70% of premiums going to claims, dividends, and administration expenses.
According to a KPMG analysis, if captives spend less than 70%, the Internal Revenue Service (IRS) considers them as “a transaction of interest.” Another red flag for the IRS: if the insurance company loans or invests any money in the parent company.
But that’s just the start, because the IRS believes that many captive entities are not providing real insurance coverage; instead, they are abusive tax shelters. In these cases, the IRS argues that the parent companies are trying to avoid tax on profits by paying premiums to the captive entity, thereby both reducing the parent firm’s income and increasing its deductions.
Captive insurance companies have been an IRS enforcement priority since 2016. And a subsequent recalculation of income and penalties can result in severe consequences—as much as 240% in some instances. Additionally, the IRS has placed onerous reporting requirements on the captives, their parent companies and the advisors that are involved in creating these entities.
Given the IRS’s concern over these entities, and its active investigation and auditing, you should only form one if there is a market necessity. And even then, you should consult legal and tax professionals at every stage—from their creation and annual operation and tax reporting.
Rod Atherton, JD
Attorney
Email Rod Atherton
(314) 454-9100
